Updated: Nov 3
Something that investors start to understand as they continue their journey into volatility trading is, this rabbit hole runs pretty deep. Understanding VIX futures and contango/backwardation is one key piece of the puzzle, but that's just scratching the surface. How far you want to go with it is entirely up to you. Now while understanding VIX futures is fairly introductory, it is a vital building block if you want to go further, and there is always further to go. For anyone who wants to learn, I'm always willing to help.
And do you want to know what my favourite day is to teach about VIX futures? The third Tuesday of every month.
That answer might sound bizarrely hyper specific, like what's wrong with this guy? He has a day of the month that he likes to explain the VIX futures? That's so superstitious! But let me explain.
The third Wednesday of every month is when the monthly VIX futures contracts expire and we start a new cycle. So the transition from the third Tuesday of the month to Wednesday the next day is where the action is. This is when you can actually see it roll over and it's clear as day what's happening.
Here's the VIX futures term structure now, Tuesday Sep 17, and I've highlighted a few of the key points we'll need:
Front month M1 = 14.81 2nd month M2 = 17.25 3rd month M3 = 18.00 VIX index = 14.89
Let's use these main points to better understand the VIX futures and how it changes day to day.
M1:M2 VIX futures contango
As it is most commonly defined, this is simply the difference in price of the front two months of the VIX futures contracts.
- If M2 > M1 then the percentage difference will be a positive number and that's called contango.
- If M1 > M2 the percentage difference is a negative number and that's called backwardation.
In our example from today:
M1 = 14.81 M2 = 17.25 M1:M2 VIX futures contango = (M2 - M1) / M1 M1:M2 VIX futures contango = 16.48%
With that value, many volatility traders use it as an input variable to try to trade the various volatility ETPs on the market like VXX, UVXY, SVXY, and of course the old XIV before its termination.
It's only one singular metric and should only ever be used as a small part of the overall picture, but in general we can say the following:
- All other things being equal, higher levels of M1:M2 VIX futures contango may be a tailwind for short volatility trades (short VXX, long SVXY)
- All other things being equal, higher levels of M1:M2 VIX futures backwardation may be a tailwind for long volatility trades (long VXX, long UVXY)
Great, we have an input variable. Like I said there are many more that should be considered as well, but let's just focus on this one. Are we ready to start trading with it? Not so fast. There's a problem here.
Today is the third Tuesday of the month. That means tomorrow:
- That front month M1 future will expire and be off the board - The current M2 VIX future will become the new M1 VIX future - The current M3 VIX future will become the new M2 VIX future - This continues down the line all the way through 8 VIX futures - M1 moves off the board, and all the futures slide down
Tomorrow, we will have a new M1:M2 VIX futures contango value, and all things being equal overnight it will be substantially lower than the current level. We can get a good rough estimate of what the new contango level will be tomorrow if the markets open in a similar spot to where they are right now.
Current M2 = 17.25 Current M3 = 18.00 Current M2:M3 VIX futures contango = 4.35%
So when using M1:M2 contango as an input variable, of course we do need to factor in the days to expiration. I call this "Adjusted M1:M2 VIX futures contango."
* I have an entire article that goes over how to do that calculation, so if you really want to see the math behind it, click here.
Here's the current values for M1:M2 contango vs adjusted M1:M2 contango right now, on Tuesday Sep 17 (these values can be seen every day in the VTS Volatility Dashboard)
- M1:M2 VIX futures contango is extremely high, above the 96th percentile of all values going back to 2004. It doesn't get much higher than this. But that's largely because expiration is today.
- Adjusted M1:M2 VIX futures contango taking into account the days to expiration is actually below average right now, in just the 39th percentile of all values back to 2004.
Knowing how to do the proper adjustment, and view the VIX futures as a dynamic indicator where each monthly value moves down the curve and eventually drops off is vital.
If you're using contango levels to try to trade volatility ETPs, it's important to use the right value right?
If you go on vixcentral.com or CBOE's website to look at the VIX futures you'll see a very high number for contango. But now you know that it's being influenced by the fact there is only 1 day left on the contract, and tomorrow we will see a much lower level of contango. When we do the necessary adjustment we can see the true contango level right now is below average.
Optional homework assignment:
After the markets open tomorrow, go to vixcentral.com and do the new M1:M2 VIX futures contango calculation and see how close it comes to our estimation of about 4-5%.
* Another thing you'll notice if you go through this exercise is, the normal M1:M2 contango value will be identical to the Adjusted M1:M2 contango value. The reason for this is simple, the new monthly VIX cycle just started. For that first day only, both the absolute and adjusted values will be the same. After that, they will start to deviate again as the VIX futures move toward the next monthly expiration.
This volatility stuff is cool right? :)
Full VIDEO explanation of VIX futures expiration here:
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